Want to say goodbye to a bad fund? Don't let taxes stop you

Summary: Investors often remain invested in an underperforming fund, fearing a tax hit. Yet, studies have shown that sticking to a laggard fund has far worse consequences than paying a one-time capital gains tax. This story explains why.

While cleaning a portfolio can be both beneficial and harmful, selling attracts tax,  especially for holdings over 4-5 years, so harmful cleaning generates higher tax. If tax is a major concern, one might avoid cleaning. Please comment – Nikhil Chitalia

Let’s say you have been investing in a flexi-cap fund for the last 4-5 years. However, the fund has underperformed expectations, delivering subpar returns repeatedly.

In such a case, what would you do? Switch to a better-performing fund? Or stay stuck with the laggard, in the hopes that it may make a turnaround?

While switching is the sensible choice, many investors hesitate to do so. Reason? Taxation.

If you sell a fund, you incur a long-term capital gains tax on the profit earned. That tax is not optional. It is immediate. So, why not avoid the pain and simply stay invested?

However, holding a poorly performing fund only drags down your returns, leaving you with less money than you should have earned. And that’s why a ‘portfolio cleanup’ is crucial.

The real meaning of ‘portfolio cleanup’

By portfolio cleanup, we don’t mean hopping or chasing after last year’s winners. It means reviewing your mutual fund holdings after a sufficient amount of time, say four or five years and then deciding whether to stay invested in an average fund or redeem and move to a better one.

Suggested read: The tidiness trap

There’s no doubt that staying invested keeps compounding uninterrupted. However, moving to a better-performing fund accelerates it, after a one-time tax hit.

Thus, the real question is not whether tax hurts. It does. The question is whether a genuinely better fund can overcome that hit within a reasonable timeframe.

Is the tax hit worth it?

Worrying about the tax hit is pointless because you are only delaying the inevitable. Whether you redeem the units today or when you retire, you will be liable for long-term capital gains tax. 

However, tax is a timing issue, not a permanent penalty. And if your long-term gains are within Rs 1.25 lakh in a year, you do not need to worry about it, thanks to the exemption. 

What matters is how fast the better fund can help overcome the tax hit. Let’s assume you invested Rs 10 lakh in an average flexi-cap fund for five years. At this point, you redeem and pay a long-term capital gains tax of 12.5 per cent on the gains (after the exemption). The remaining amount is immediately reinvested into a new fund.

Now comes the important question: How much extra return is worth making the switch for? To find out, we tested five scenarios in which the new fund earns one, two, three, four or five percentage points more than the previous fund from this point onward. We then compare two paths over the next five years: one, you stay in the average fund at 12 per cent and two, you clean up, pay tax and move to the superior fund. The difference between the two outcomes is what your cleanup decision is truly worth.

The data above clearly shows that making the switch yields long-term benefits. While the difference may not be significant if the new fund earns only 1 per cent more, the gains become substantial when the extra return increases gradually. Not only do you end up with a higher corpus after five years, but the time taken to recover from the tax hit reduces significantly. In such cases, the capital gains tax looks less like a roadblock and more like a one-time entry fee for a better compounding engine.

The bottom line

Taxes are a reality of investing. But they should not stand in the way of building long-term wealth. Staying invested in a mediocre fund simply to avoid a tax bill can hurt you more in the long run. It not only drags down your portfolio’s performance, but it also limits your ability to earn better returns elsewhere.

That said, this is not an invitation to chase last year’s top performer or switch funds based on their one-year returns or rankings. Constant churn can do far more damage than good, especially by disrupting the power of compounding.

Suggested watch: Switching Funds: When, Why, and How?

Consider exiting only when a fund has consistently underperformed over a meaningful period and there is a clear reason to believe it is unlikely to improve. Thoughtful decisions build wealth. Impulsive ones rarely do.

If you want more clarity and expert-led guidance on whether to sell off or move to better-performing funds, subscribe to Value Research Fund Advisor and accelerate your wealth-building journey.

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This article was originally published on February 16, 2026.